Accounting cops have tough task of cracking down on corporate fraud

Pat Sullivan / AP

A woman leaves Enron headquarters on Nov. 28, 2001, in downtown Houston, days before the energy trading company filed for bankruptcy. The Enron scandal led to the dissolution of its audit firm, Chicago-based Arthur Andersen.

A woman leaves Enron headquarters on Nov. 28, 2001, in downtown Houston, days before the energy trading company filed for bankruptcy. The Enron scandal led to the dissolution of its audit firm, Chicago-based Arthur Andersen. (Pat Sullivan / AP)

When it comes to policing corporate fraud, independent auditors are supposed to be the cops on the beat, but too often they miss or overlook important clues that signal big trouble is brewing.

That's among the conclusions of a recent research paper by accounting and business experts from the University of Illinois at Urbana-Champaign and Duke University that stresses auditors have much to learn about being crack corporate crime-stoppers.

Certainly, there's enough work to go around since the estimated average annual cost of fraud among large U.S. companies is about $380 billion, according to another academic report. The FBI's list of top corporate swindles includes: Cooking the books with false accounting entries, executing fraudulent actions or trades designed to inflate profits or hide losses, making illicit transactions to evade regulators, accepting or giving kickbacks and, that old standby, insider trading.

Such research underscores a depressing point: Corporate fraud is pretty pervasive and stepped-up rules and regulations designed to curb abuses often fall short when confronted by human greed. Among those laws is the Sarbanes-Oxley Act of 2002, a reform measure passed in the aftermath of financing scandals that sparked the collapse of Texas-based Enron and ultimately the dissolution of its audit firm, the locally based Arthur Andersen.

"Regulators are concerned and want the auditors to detect fraud. But auditors, frankly, are not very good historically at finding it," said Jessen Hobson, an associate professor of accountancy at the U. of I., who co-wrote a research paper examining the issue with colleague Mark Peecher, U. of I. associate dean of faculty and Deloitte professor of accountancy, along with Duke accounting experts.

Auditors have trouble sniffing out bad numbers? If that strikes you as odd and counterintuitive, you are not alone.

But the U. of I.'s academic duo points out that there are stumbling blocks built into the company auditing process that hinder inquiring, investigative minds.

Keeping the customer happy is one of them.

A public company hires, and pays a lot of money, for auditors to act as independent outsiders to keep tabs on books. Still, the conventional criticism is that when nagging questions or warning signs flare up, these paid skeptics will give top management the benefit of a doubt or side with their explanations.

One reason to be accommodating is that calling foul is serious business and auditors must be very sure of their ground before taking that step. The U. of I. researchers note that less experienced auditors sometimes flag a transaction or entry as fraudulent only to have a more experienced accounting hand explain why it isn't.

Sears Holdings' chance of survival is being called into question by none other than the company itself, which now concedes it has "substantial doubt" about sticking around.

That recent revelation, made in its annual report, is not unexpected. Sears is a longtime corporate life-support case. But...

Sears Holdings' chance of survival is being called into question by none other than the company itself, which now concedes it has "substantial doubt" about sticking around.

That recent revelation, made in its annual report, is not unexpected. Sears is a longtime corporate life-support case. But...

(Robert Reed)

"Crying 'wolf' too often is counterproductive. You do need that seasoned auditor to be involved," said Peecher.

Yet even veteran number-crunchers aren't always in the game when it comes to rooting out systemic fraud and bad behavior. They have their blind spots too.

The U. of I. researchers contend auditors could be trained to get a sharper sense of their clients' condition by observing the way CEOs and top managers act outside the corporate suite. For instance, they recommend auditors monitor, preferably in real time, the question-and-answer segments of quarterly conference calls with investment analysts who track the company.

You'd think this would be a common practice but often it isn't because auditors will rely instead on their direct conversations with CEOs and corporate ledger-watching expertise.

Yet in these unscripted settings, the CEO's way of responding to negative questions, reacting to tough questions or framing the company's objectives can ring a warning bell that signals something screwy may be going on.

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This exploratory approach should also apply to annual shareholder meetings and so-called road shows, when companies make investor presentations.

"You learn what smart equity analysts are worried about and if management has good, strong answers or shows negative emotion and is flustered … which may indicate if the business is going to cross the line which heightens a sense of fraud risk," said Peecher.

How pervasive is corporate fraud?

Even with new anti-corruption regulations, it's estimated that one out of seven firms suffers from ongoing fraud, according to an August 2014 research paper co-written by Luigi Zingales, a professor at the University of Chicago. (Experts from the University of Toronto and University of California at Berkeley also contributed).

Let's hope more auditors heed the recent research and strive to get better at sleuthing out corporate fraud and corruption.

A version of this article appeared in print on April 06, 2017, in the Business section of the Chicago Tribune with the headline "Accounting cops have a difficult assignment - Corporate fraud up; prevention efforts lag, researchers say" —
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